Crunch time for emerging markets

The last emerging-market (EM) rout was rescued by the Fed; a reprise may be wishful thinking this time.

Key takeaways

• Emerging markets are back in focus, with financial turmoil hitting Turkey.
• Unlike 2016, when the U.S. Federal Reserve took pressure off emerging markets by slowing its pace of monetary tightening, this time the Fed may not have that luxury.
• That means that there are likely no quick fixes to EM problems.
• Meanwhile, the U.S. stock market is back near its January highs, but I think enough potential headwinds are out there to keep the now six- month-old trading range intact.
• 2019 could prove a pivotal year for U.S. stocks, as I see earnings growth slowing back to trend by then and the Fed getting further and further into restrictive policy.

Investors are watching EM

With Turkey exploding back into the headlines—the Turkish lira has lost close to 40% of its value year to date through August 151—it’s a good reminder that although the U.S. economy remains strong, the same cannot be said across the emerging markets. And unlike what happened in 2016, this time around we likely can’t count on the U.S. Federal Reserve to open the liquidity spigot and, in turn, dampen U.S.-dollar strength.

While the S&P 500® is back near its all-time high (reaching 2863 on August 7, 2018, versus the 2873 record set in January), the MSCI World ex USA Index is down around 12% since its January 26 peak and the MSCI Emerging Markets Index is down nearly 20%, within which Turkey was off a whopping 55% (all data as of August 15). Moreover, the Euro Stoxx® Banks Index is down some 26%. European banks always seem to have a front row seat to the happenings in emerging markets. In this case it’s the Spanish banking system where the biggest exposures are.

On its own, I don’t think Turkey should pose that much of a systemic risk to the U.S. or global markets. Like Argentina, Turkey is only a small part of the EM index, and it is not a highly indebted country overall (debt/GDP there is a little over 40%, although that ratio is roughly double if one looks just at credit to the non-financial sector versus GDP). But a fair amount of sovereign and corporate debt is in foreign hands, which is always risky. Therefore, the crisis could develop into contagion if Turkey imposes capital controls to stem the bleeding.

This in turn could lead to investors unwinding positions elsewhere (as the old adage goes: if you can’t sell what you want, sell what you can). So far this has not happened, and it is not our base case. But clearly this is an important line in the sand for Turkey and, more generally, EM equities as an asset class. (Keep in mind, though, that the World Bank ranks Turkey as only the 17th largest economy as of 2017, with a GDP less than Apple’s current market cap!)

Turkey is not the only news of course. China is another developing story and could indeed prove to be systemic for global markets. The Chinese economy has been doing OK in the grand scheme, but it has been slowing in recent months, to the point where the government is now easing fiscal and monetary policy. Indeed, China seems to be following its two-year CRIC cycle2 (crisis. response. improvement . complacency) with good accuracy.

The problem with China’s slowdown and concurrent policy easing is that it is happening at a time when the U.S. economy is strong and the Fed is tightening. Because China’s currency is tied to the U.S. dollar, China is essentially importing U.S. monetary policy. That’s fine when the two economies are synched up, but not when they are diverging, as is presently the case. The result of all this is that the Chinese yuan has fallen back near its 2015–2016 lows. So far, China’s currency depreciation is not as systemic as it was in 2016 (evidenced by the stability of its foreign-currency reserves), but it’s something that should be watched.

Trade remains an obvious concern, of course. The risk is that escalating trade tension could lead to “stagflation,” resulting in P/E (price-earnings) compression around the world. With the S&P 500® near all-time highs and, as of August 15, the Shanghai Stock Exchange Composite Index down about 23% since January 26, it’s easy to declare winners and losers, but rising tariffs could cause a one-two punch for all markets in the form of declining profit margins coupled with rising prices. If there is one thing we’ve learned from studying economic history, it’s that stagflation equals a headwind for valuations.

EM equities continue to track the 2014–2016 analog with close precision, despite the fact that the earnings backdrop in emerging markets is better today than it was a few years ago. Exhibit 1 (on page 3) shows the analog across various metrics and links the two periods to the point at which liquidity conditions (as measured by the Goldman Sachs Financial Conditions Index) started to tighten (August 2014 versus January 2018).

The last EM rout ended in early 2016 when the U.S. Federal Reserve was forced to dial back on its hawkish forward guidance. In effect, the Fed “eased” simply by tightening less than the markets had priced in, proving once again that we live in a “flow” and not a “stock” world (i.e., rate of change matters more than absolute level).

But that was two and a half years ago. Back then the Fed had the luxury of operating in a regime of secular stagnation (or at least persistently anemic growth) and inflation was well below target, which allowed the Fed to ease off the throttle in terms of its tightening path.

The Fed had nothing to lose by not tightening as quickly as it had telegraphed; the impact was the same as a rate cut.